Working Paper No.

M. T. Raju, Upasana Bhutáni, Anubhuti Sahay

Working Paper Series No. 9

The views expressed in this paper are those of the authors and do not necessarilyreflect those of the Securities and Exchange Board of India. We sincerely thankShri G. N. Bajpai, Chairman, SEBI for his unlimited support and encouragementin conducting research work. But for him, it would not have been possible tobring out this paper timely. We also thank many of our colleagues for theircomments and suggestions.

-2-Contents

q Foreword……………………………………………….

q Acknowledgement…………………………………….

q SEBI………………………………………………………

q Abstract…………………………………………………. 05

q Objectives of the Study……………………………… 06

q Motivation……………………………………………… 07

q Introduction …………………………………………… 08

q The Indian Debt Market……………………………… 09

q Micro Structure of the Debt Market………………… 13

q Issues of Concern……………………………………… 18

q Recent Initiatives by SEBI…………………………… 24

q Recommendations……………………………………… 27

q Conclusion………………………………………………. 37

q Bibliography……………………………………………… 38

q SEBI Working Paper Series…………………………….. 39

-3- ForewordFinancial Markets have several facets and are segregated into Capital and Moneymarkets. Product based classification gives rise to segmentation of market intoequity, debt, foreign exchange and futures.

In many countries, debt market (both sovereign and corporate) is larger thanequity markets. In fact, in matured economies debt market is three times the sizeof the equity market. Investment in equity being riskier, certain class of investorschoose to invest in debt, based on their risk appetite and liquidity requirements.In fact, most investors like to spread their investments into equity, debt and otherclasses of assets for reasons of optimal combination of return, liquidity andsafety.

depending upon the expected changes. Debt market, in particular, providesfinancial resources for the development of infrastructure. Hence, a well-functioning debt market becomes significant for all the market participants.

The robustness of Indian debt market, notwithstanding some of major initiatives

taken recently , leaves much to be desired. It was, therefore, felt in line with ourregulatory responsib ility of developing the market that greater focus should beprovided by SEBI on development of debt market. With this underlying thought,the Research Department started working on the project and have produced afairly comprehensive working paper.

The working paper outlines the significance of debt market in general and its rolein accelerating the development of economic growth in particular. It reviewsvarious regulatory and non-regulatory developments, instruments available,investors, issuers and intermediaries in the Indian context. The paper alsoidentifies several weaknesses in the present system along with areas hinderingthe growth of debt market. Recommendations of the paper include developmentof corporate debt repo market, institution of debt manager, sound safe androbust infrastructure, regulatory framework, investor profile and comprehensivedatabase.

-4-I congratulate the team of Research Department for the hard work they put inbringing out a quality paper.

July 2004 G.N. Bajpai

Mumbai Chairman, SEBI

-5- AcknowledgementThe authors of this paper are immensely grateful to Shri G N Bajpai,Chairman, SEBI for his unstinting guidance and support throughout theproject. He has been a tremendous source of inspiration and motivation to allof us. Whole Time Members ,Shri T M Nagarajan and Shri A K Batra ,havebeen providing continuous support and suggestions in conducting variousresearch studies. Their comments on this paper have also become veryuseful. Our thanks are due to them. Shri P K Mishra, Executive Director,Research Department provided all necessary support in bringing out thispublication.

Ashok Lahiri, Chief Economic advisor, MoF, GoI, Dr Kaushik Basu, CornellUniversity, Dr. Arvind Virmani, Director and Chief Executive, ICRIER, DrRaghuram Rajan, IMF, Washington, Dr Marti Subramaniam, New YorkUniversity, , Dr. K C Mishra, National Insurance Academy, Devdutt Shah andDr Suman Bery, NCAER, New Delhi, members of Market DevelopmentAdvisory Committee for sharing many of their valuable insights with us andfor excellent research guidance. The overall guidance provided by them wasfundamental to the structure and content development of this paper. We areprofusely thankful to the team from World Bank for their suggestionsexpressed during an interactive session as well as the written materialprovided by them. We also acknowledge the contribution of the variousmerchant bankers, primary dealers, broking firms, mutual funds for havingenlightened us on the ground realities of the Indian debt market.

Our special acknowledgements to Shri Manish Bansal for his thoughtful

inputs. In addition the authors also wish to acknowledge Shri Umesh Kumar,for helpful comments and suggestions.

The team wishes to express its gratitude for the support provided by Shri C RUnny, GM, Treasury and Accounts Division, SEBI, for providing necessarysupport in bringing out this publication.

-6- Securities and Exchange Board of India

The Securities and Exchange Board of India (SEBI) was constituted on 12 April1988 as a non-statutory body through an Administrative Resolution of theGovernment for dealing with all matters relating to development andregulation of the securities market and investor protection and to advise thegovernment on all these matters. SEBI was given statutory status and powersthrough an Ordinance promulgated on January 30 1992. SEBI was establishedas a statutory body on 21 February 1992. The Ordinance was replaced by an Actof Parliament on 4 April 1992. The preamble of the SEBI Act, 1992 enshrines theobjectives of SEBI – to protect the interest of investors in securities market andto promote the development of and to regulate the securities market. Thestatutory powers and functions of SEBI were strengthened through thepromulgation of the Securities Laws (Amendment) Ordinance on 25 January1995, which was subsequently replaced by an Act of Parliament.

-7- Abstract

This paper presents an overview of the corporate debt market in India. A studyof the structure and the status of the corporate debt market along with thecurrent policies initiated by Securities and Exchange Board of India , help toidentify the associated structural problems in this segment. Based on a detailedanalysis of these identified problems, this paper recommends certain steps,which can help to activate the corporate debt market and to become an importantsource of finance for the economy.

-8- Objectives of the Study

There are several empirical /theoretical studies conducted out to bring

developments and status of Indian Corporate Debt Market and to makesuggestions to convert it into vibrant market. This paper has some of thefollowing objectives:-

§ Review regulatory and market related developments for the past years inIndia.§ Identify structural gaps or deficiency in the Indian Debt Market.§ States recent regulatory changes and their impact on the market.§ Make suggestions /recommendations to develop Indian Corporate Debtmarket as one of most vibrant / liquid transparent and efficient market places.

to have complete markets as they provide investors with opportunities to shifttheir investment across instruments over time depending on expectations andchanges. In India for past several years, reforms have been initiated to developdebt market in general and corporate debt market in particular. Despite all this,corporate debt market in India still lacks depth and breadth. Therefore, thepresent study has been taken up to review the past developments, to identifyweakness/gaps and suggest suitable measures to develop the market.

- 10 - I. Introduction

The role of a healthy corporate debt market as a channel that links society’ssavings into investment opportunities is of vital importance for several reasons.

For the issuer it provides low cost funds by bypassing the intermediary role of abank. Although corporations have to go through intermediaries like brokers,underwriters in the debt market too, the intense competition amongst thempushes down intermediation cost . Presence of bond funds gives the corporationsan alternative means of raising debt capital and thus ameliorates any potentialadverse effect that a bank credit crunch may have on the economy.

For the investor, there exists a yield premium opportunity in comparison to

traditional deposits at banking institutions. It also increases the investmentopportunities in different type of instruments and tailors risk reward profileaccording to his/her preferences.

The basic philosophy of developing a diversified financial system with banks

and non-banks operating in equity market and debt market is that it enhancesrisk pooling and risk sharing opportunities for investors and borrowers.

The importance of a well-developed bond market is very well summarised in the

following words “co-existence of domestic bond market and banking systemhelps each to act as a backstop for the other…In a relatively open economy sincenon- bank intermediation may get located outside the country...the domesticbond market helps in avoiding double mismatches of currency and maturity.” 1

It is in the above perspective that we seek an examination of the nature of

development of the ‘Indian Debt Market’. The paper is divided into six parts.Part II introduces the debt market in India followed by part III that gives aschematic presentation of the microstructure of the corporate debt market inIndia. Part IV addresses the issues concerning it. Part V deals with the recentinitiatives undertaken by SEBI with respect to the debt market. Part VI givesrecommendations for developing the corporate debt market in India.

1 Dr Reddy. Y V (2002) when he quoted Alan Greenspan in a key note address at the Asian BondConference on March 11, 2002.

- 11 - II. The Indian Debt MarketThe debt market is much more popular than the equity markets in most partsof the world. In India the reverse has been true. This has been due to thedominance of the government securities in the debt market and that too, amarket where government was borrowing at pre-announced coupon ratesfrom basically a captive group of investors, such as banks. Thus there existeda passive internal debt management policy. This, coupled with automaticmonetisation of fiscal deficit prevented a deep and vibrant governmentsecurities market.

The debt market in India comprises broadly two segments, viz., GovernmentSecurities Market and Corporate Debt Market. The latter is further classifiedas Market for PSU Bonds and Private Sector Bonds.

The market for government sec urities is the oldest and has the mostoutstanding securities, trading volume and number of participants. Over theyears, there have been new products introduced by the RBI like zero couponbonds, floating rate bonds, inflation indexed bonds, etc. The tradingplatforms for government securities are the “Negotiated Dealing System” andthe Wholesale Debt Market (WDM) segment of National Stock Exchange(NSE) and Bombay Stock Exchange (BSE).

The PSU bonds were generally treated as surrogates of sovereign paper,

sometimes due to explicit guarantee of government, and often due to thecomfort of government ownership. The perception and reality are twodifferent aspects. The listed PSU bonds are traded on the Wholesale DebtMarket of NSE.

The corporate bond market, in the sense of private corporate sector raisingdebt through public issuance in capital market, is only an insignificant part ofthe Indian Debt Market. A large part of the issuance in the non-Governmentdebt market is currently on private placement basis. Tables 1, 2 and 3 providedetails of amount raised by financial institutions and non-financialinstitutions by way of public issue and private placement. From the tables, itis clear that, on an average private placement accounts for little over one-third of the debt issuance. Unofficial estimates indicate that about 90 per centof the private corporate sector debt has been raised through privateplacement in the recent past. The amount raised through private placementhas been continuously rising for the past five years which increased by morethan 300 per cent over the five year period. The growth rate in the public

- 12 - issue processes is only about 80 per cent over the period, increasing from Rs. 20896 crore to Rs. 36466 crore. The listed corporate bonds also trade on the Wholesale Debt Segment of NSE. But the percentage of the bonds trading on the exchange is small. The secondary market for corporate bonds till now has been over the counter market. With the recent guidelines issued by SEBI the scenario is expected to change.

- 13 - III. Market Micro StructureIt is necessary to understand microstructure of any market to identifyprocesses, products and issues governing its structure and development. Inthis section a schematic presentation is attempted on the micro-structure ofIndian corporate debt market so that the issues are placed in a properperspective. Figure 1 gives a bird’s eye view of the Indian debt marketstructure.

Indian Debt Market has almost all possible variety of issuers as is the case inmany developed markets. It has large private sector corporate, public sectorundertakings (union as well as state), financial institutions, banks and mediumand small companies: Thus the spectrum appears to be complete. Figure 1,delineates details on various classes of issuers. Two main classes include privatesector corporates and banks.

ii) Instruments

Figure 1 provides names of some of the more popular instruments that have beenissued. Till recently Indian debt market was predominantly dominated by plainvanilla bonds. Over a period of time, many other instruments have been issued.They include partly convertible debentures (PCDs), fully convertible debentures(FCDs), deep discount bonds (DDBs), zero coupon bonds (ZCBs), bonds withwarrants, floating rate notes (FRNs) / bonds and secured premium notes (SPNs).The coupon rates mostly depend on tenure and credit rating. However, thesemay not be strictly correlated in all cases. The maturities of bonds generally varybetween one year to ten years. However, the median could be around four tofive years. The maturity period by and large depends on outlook on interestrates. In expectation of falling interest rates environment, corporate, it isobserved, mostly go to shorter term instruments while the opposite is true incase of possible hike in interest rates. For the past few years interest rates havebeen falling and short end issues are on the rise. This is one of the reasons thatmany corporate are reluctant to go for public issue route and listing of theirsecurities.

iii) Processes

There are several processes that are in vogue in India as well as in other markets.The more popular ones are public issue and private placement routes. Both thesehave their own pros and cons. In a mature and developed market where large

- 15 -number of institutional investor /sophisticated investors are available and ahighly developed mutual fund industry is in operation, the private placementroute may be acceptable to issuers, investors and regulators. In a less developedmarket / small market it is a catch 22 position. Private placement is not suitablebecause this market do not have adequate number of informed investors and thepublic issue route may create regulatory arbitrage, higher compliance costsresulting sometimes in migration of markets. In India private placem ent route ishighly popular owing to various reasons (These are given in the following Box1).

Box 1- Reasons for Dominance of Private Placement

The dominance of private placement in total issuances is attributable to thefollowing factorsØ Under private placement, the deals can be tailor made to suit requirements ofboth the issuer and the investor.Ø The mandatory lengthy issuance procedure for public issues, in particular,the information disclosure requirements, was not applicable to private placementand this provided a strong incentive for eligible entities to opt for privateplacement. Also listing of bonds on stock exchange was not required.Ø It is observed that private placement route generally involves lower issuancecosts.

iv) Intermediaries

Two classes of intermediaries required for the proper development of debt

market are broker and investment banker/ merchant banker. Most of the brokersas well as merchant bankers in India are inadequately capitalized and theirprofessional knowledge also needs further improvement. In some markets, it isobserved that there are dedicated “Debt Manager s” who facilitate subscriptionor sometimes subscribe to the issue and later on even facilitate trading in bonds.India needs a dedicated “Bond Manager” concept.

v) Investors

For the development of Corporate Debt Market / Fixed Income Securities Market,it is necessary and sufficient to have a large as well as diverse number ofsophisticated / institutional investors. Figure 1 lists some of the classes ofinvestors that have been investing in the debt market. Institutional Investors inIndia are few in number and the variety also is limited. We have only 37 mutual

- 16 -funds, hardly five insurance companies till recently and there are no pensionfunds. Banks and financial institutions, by and large, do not take active interestin Corporate Debt Market. Investors with diverse expectations are a preconditionfor the development of corporate debt market. Diversity could be in terms ofmaturity needs as well as expectations on interest rates. The most importantstructural weakness in India is lack of large and diverse institutional investors.

India has large number of retail investors; however, their expectations are quitecontrary to market principles - risk and return. Most investors think and perceivethat investments in bonds should provide them guarantee, repayment ofprincipal and regular payment of coupons. Any delay/default causes worries intheir minds. And sometimes these investors complain to regulators or to thegovernment for non receipt of coupons or non-repayment of principal. This typeof behaviour implies lack of understanding of the principles of the capital marketon the part of the investors.

vi) Rating agencies

India has a well developed Credit Rating Agency system and rating agencies arewell experienced and regarded. By and large, their ratings do carry confidencein the market.

2) Some of the Structural Weaknesses identified in the Primary Market are :

The National Stock Exchange (NSE) introduced a transparent screen- based

trading system in the whole sale debt market, including government securities inJune 1994. The wholesale debt market (WDM) segment of NSE has beenproviding a platform for trading / reporting of a wide range of debt securities.

The WDM trading system , known as NEAT (National Exchange for AutomatedTrading), is a fully automated screen based trading system, which enablesmembers across the country to trade simultaneously with enormous ease andefficiency. The trading system is an order driven system, which matches best buyand sell orders on a price/time priority.

Trading system provides two market sub-types:

do not know each other and they put their best buy/ sell orders, which are storedin order book with price/time priority. If orders match, it results into a trade. Thetrades in WDM segment are settled directly between the participants, who takean exposure to the settlement risk attached to any unknown counter-party. In theNEAT-WDM system, all participants can set up their counter-party exposurelimits against all probable counter-parties. This enables the tradingmember/participant to reduce/minimize the counter-party risk associated withthe counter-party to trade. A trade does not take place if both the buy/sellparticipants do not invoke the counter-party exposure limit in the tradingsystem.

Ø Negotiated Market: In the negotiated market, the trades are normally

decided by the seller and the buyer, and reported to the exchange through thebroker. Thus, deals negotiated or structured outside the exchange are disclosedto the market through NEAT-WDM system. In negotiated market, as buyers andsellers know each other and have agreed to trade, no counter-party exposurelimit needs to be invoked.

ii) Clearing and Settlement Mechanism

directly with the participants and the exchange monitors the settlement. Mostlythese trades are settled in Mumbai. Trades are settled gross, i.e. on trade for trade

- 18 -basis directly between the constituents / participants to the trade and not throughany clearing house mechanism. Thus, each transaction is settled individually andnetting of transactions is not allowed.

Settlement is on a rolling basis, i.e. there is no account period settlement. Each

order has a unique settlement date specified upfront at the time of order entryand used as a matching parameter. It is mandatory for trades to be settled on thepredefined settlement date. The Exchange currently allows settlement periodsranging from same day (T+0) settlement to a maximum of two business daysfrom the date of trade (T+2).

From Table 4, a highly skewed pattern can be observed in trading of debt

instruments. In 1994-95 government securities used to account for less than 50per cent of the total trades reported, in 2002-03 the same went up to about 94percent which is more than double. All other segments account for a little oversix percent

iv) Investors in WDM

Large investors and a high average trade value characterize this segment. Tillrecently, the market was purely an informal market with most of the tradesdirectly negotiated and struck between various participants. The commencementof this segment by NSE has brought about transparency and efficiency to thedebt market, along with effective monitoring and surveillance to the market.

The listed corporate debt is under the regulations of SEBI. SEBI is involvedwhenever there is any entity raising money from Indian individual investorsthrough public issues/ private placement. It regulates the manner in which suchmoneys are raised and tries to ensure a fair play for the retail investor. It forcesthe issuer to make the retail investor aware of the risks inherent in theinvestment. SEBI has in fact laid down guidelines known as Disclosure andInvestor Protection (DIP) Guidelines, 2000 guidelines to maintain transparency inthe market and make it efficient.

2) Some of the Structural Weaknesses identified in Secondary Market

(i) Absence of Clearing Corporation and CCPS.

(ii) Dedicated trading platform.(iii) Exclusive, well capitalized and professional intermediaries.(iv) Lack of reliable and up to date information.

- 20 - IV. Issues of Concern

After reviewing functioning of debt market in some other markets and in India,the following issues have been identified as some of the major aspects affectingthe market.

a) Poor Quality Paper

Quality of paper refers to regular payment of coupon and repayment of principal

at the right time. Companies that do not default on these two counts are said tobe issuing high quality paper. High quality paper issued in the market does notcreate problems / issues for investors, regulators and issuers. The question ofprivate placement vs. public issue and institutional investors vs. retail investorare of less significance and almost no consequence in the market, if the quality ofthe paper is good.

It is the poor quality paper with a possibility of non-payment of coupon and

principal that poses threat to the development of the market and hence stringentregulatory norms are warranted.

Imposition of additional regulatory provisions, though has its opportunity cost,

therefore, it is essential to strike a balance between regulatory protection anddisclosure based regulation.

Further, in an emerging market / developing market the incidence of industrial

sickness is relatively high. This high industrial sickness generally translates intodefault of companies and their obligations. The bond paper issued by companiesturns worthless and creates problem s in the minds of investors. Since mostretail investors, who invest in bonds, hold for maturity and also hold theirinvestment in a fewer number of companies, any default will wipe out theirsavings and security for the post retirement / old age requirements. Therefore,defaults in fixed income securities market attract more attention of the publicand the regulators.

b) Inadequate liquidity

Secondary Market for Corporate Debt lacks liquidity in India. Hardly few tradestake place, that too, in a limited number of issues. There is a chicken and eggproblem. Poor liquidity is attributable to inadequate number of good papers and

- 21 -lack of sufficient investor base in terms of quantity as well as diversity. We canaddress the liquidity issue in the following ways:

1) By developing ‘bond manager’;

2) By enlarging number of investors;3) By introducing good quality paper.

The third factor is exogenous and the second will take long time. Therefore,what is feasible and achievable in the near term is the development of ‘bondmanager’ so that liquidity issue can be addressed and to some extent the qualityof paper also.

In many markets the number of investors in fixed income securities market runsinto thousands and their variety include mutual funds, insurance companies,pension funds, endowments, private banking institutions, banks and retailinvestors. In India, we have primarily mutual funds investing in bond funds andtheir investment requirements are one sided, if money starts coming in allmutual funds will get in large quantities and if it starts going out it will go inhuge quantities thus creating storms in the market. Insurance funds and pensionfunds are the long term investors. Any short term shocks can be absorbed bythese long term players. Insurance companies in India till recently were limitedin number and they were investing to hold till maturity. Individual investorsgenerally hold for maturity. Now that we have more private sector and joint

- 22 -sector players, their presence in the primary as well as in the secondary marketcan be felt in the time to come. Pension funds are not there today. Banks doinvest in the primary market and their activity in the secondary market is almostnil.

d) Regulatory arbitrage ( additional costs on listed companies)

Companies operating in India can be broadly divided into two categories on thebasis of regulatory jurisdiction: Listed and Unlisted. All companies are, by andlarge, administered by the Companies Act, 1956 and the regulatoryadministration is carried out by DCA, Ministry of Finance.

Listed companies are overseen by SEBI through Listing Agreement of exchanges.

e) Debt Versus equity : Cost and risks

By design and necessity debt has finite life sometimes, very short whereas equityis said to have perpetual life. Therefore, debt paper is offered and reoffered quitefrequently by companies. In falling interest rate scenario, as has been the case inIndia for the past few years, corporates tend to borrow for shortest possibleperiod thus restoring to repeated issue costs and interest rate risks. Highregulatory and compliance costs add to cost of resources. Therefore, corporatesmight innovate new methods of raising capital. Either way, the corporate debtmarket will be affected adversely.

f) Incomplete access to information

One of the most important issues is lack of sufficient, timely and reliableinformation on bonds and on bond markets to the investors. Information onbond issue, size, coupon, latest credit rating, trade statistics are sparselyavailable. If the investors have access to the relevant information morefrequently then it may be possible for them to assess the quality of the paper andtake decisions.

In addition, there is no one place in India where one can have all the datapertaining to corporate debt issues. No one knows exactly how much debt is

- 23 -outstanding on any given date and different agencies have incoherent estimatesfor the same. Tables 1 and 2 amply demonstrate this point. Annual public issueamount averages around Rs. 40,000 crore for the past 3 years. If the entire 5 yearperiod is considered roughly Rs. 170,000 crore was raised through public issue.However, the amount of debt outstanding for trading at NSE excludinggovernment securities and treasury bills comes to roughly Rs. 100,000 crore.There is a wide gap between publicly issued amount and that which is admittedfor trading even if one considers average maturity period of five years. Generallybonds have longer maturity. Hence, any regulatory action either becomesineffective or misdirected leading to unintended results target. Therefore, thereis an urgent need to launch a survey and prepare a comprehensive database andbring in transparency. Transparency ensures confidence which in turn ensuresliquidity. Sudden shocks can be mitigated.

g) Interest rate structure

Very skewed interest rate structure exists in India. Corporates with “AAA”rating offer lower coupon than soverign rate offered on certain instruments suchas public provident fund, National Saving Certificates. Individual investors,therefore, have almost nil or no interest in coupon debt market, both primary aswell as in secondary, unless they are accompanied by some fiscal concessionsresulting in net higher return compared to above cited instruments.

- 24 - V. Recent Initiatives by SEBI and their Impact on the MarketIn the past few months SEBI had initiated a slew of measures in order to properlypromote primary and secondary corporate debt market in India.

a) Primary Market :

Any constituent of the corporate debt market can issue bonds/debentures

through public issues and private placements. To be able to make a public issuethe issuer has to meet the statutory requirements prescribed in the Disclosureand Investor Protection Guidelines. These are given in Box 2.

Box 2: Statutory requirements for public issues as specified in DIP guidelines

In case of a debenture issue, the company has to give undertakings to the

following effect in the offer document as well:

i. The company has to forward the details of utilization of the funds raisedthrough the debentures duly certified by the statutory auditors of the company,to the debenture trustees at the end of each half-year.

ii. The company has to disclose the complete names and addresses of thedebenture trustees in the annual report.

iii. The company has to provide a compliance certificate to the debenture holders(on yearly basis) in respect of compliance with the terms and conditions of issueof debentures as contained in the offer document, duly certified by the debenturetrustees.

iv. The company has to furnish a confirmation certificate that the security createdby the company in favour of the debenture holders is properly maintained and isadequate enough to meet the payment obligations towards the debentureholders in the event of default.

v. Credit rating of not less than investment grade is obtained from not less thantwo credit rating agencies registered with SEBI and disclosed in the offerdocument.

vi. The company is not in the list of wilful defaulters of RBI.

- 25 -vii. The company is not in default of payment of interest or repayment ofprincipal in respect of debentures issued to the public, if any, for a period ofmore than 6 months.

viii. An issuer company can not make an allotment of non-convertible debt

instrument pursuant to a public issue if the proposed allottees are less than fifty(50) in number. In such a case the company shall forthwith refund the entiresubscription amount received. If there is a delay beyond 8 days after thecompany becomes liable to pay the amount, the company shall pay interest@15% p.a to the investors.

ix. Where credit ratings are obtained from more than two credit rating agencies,all the credit rating/s, including the unaccepted credit ratings, have to bedisclosed.

x. All the credit ratings obtained during the three (3) years preceding the pubic orrights issue of debt instrument (including convertible instruments) for any listedsecurity of the issuer company shall be disclosed in the offer document.

The public issue can come as an open offer to public at large or involve a bookbuilding process. Book building is a process by which demand for the securitiesproposed to be issued by a corporate is elicited, built up and the pricedetermined on the basis of the interplay between demand and the quantum ofthe securities to be issued.

The public issues market has over the years been dominated by financialinstitutions, which is exemplified by the fact that ICICI and IDBI accounted forthe entire debt offerings in 1998–99 and all but one issue in 1999–2000. Anotherinteresting fact is that inspite of dominating the public issues market evenfinancial institutions have raised significantly larger amounts through the privateplacement route.

Total resource mobilisation from the private placement market increased sharplyby over 3-fold between 1997-98 and 2001-02, The share of private placementissues in total mobilisation from the primary capital market (public issues andprivate placements) for non financial institutions increased from about 30percent in 1997-98 to around 85 per cent by 2000-2001.

- 26 -On September 30, 2003, SEBI, in order to provide greater transparency toprivately placed issues and to protect the interest of investors in such securities,issued a circular stating guidelines that any listed company making issue of debtsecurities on a private placement basis and listed on a stock exchange has tocomply. SEBI has in the meanwhile granted a transition period up to March 31,2004 to those issuer companies who had issued privately placed debt securitiesbut did not list those securities prior to September 30, 2003 (the date of theCircular) to enable them to comply with the provisions of the Circular.

1) ObjectivesPrimary market guidelines issued by SEBI and changes made by exchanges aresupposed to have been aimed to enforce:

2) The Fallout of SEBI Guidelines

It is possible that highly rated companies might have attraction to explore

alternative sources of finance which are cheap, easily available and have lessstringent covenants. Companies with low credit rating or companies withoutbetter alternative sources might use public issue of debt paper and seek listing onstock exchange. In fact, this could be a counterproductive outcome that willproduce poor quality paper leading to possible defaults. If these defaults aremore in number then there are chances that the market development will gethampered. Some of the likely fallouts are discussed below:

i) Increased reliance on credit markets

More and more companies particularly highly rated ones would go to banks andraise loans with flexible covenants. Coupon tenor and rescheduling are the mainfactors that weigh in favour of loans. Only companies that do not have access tobank credit on favourable terms are likely to use capital market route.

- 27 -ii) Migration to Overseas Market

Since funds are generally available cheaply in the overseas market, manycompanies try to access ECB, Yankee bond market or they can use ADR/ GDRroute also.

iii) Reliance on equity

One of the typical attitudes, on the basis of past behaviour of Indian corporate, isto go for equity financing, whenever markets are on rise. Though, theoreticallyand practically equity is considered to be costlier than the debt it is observed thatthe equity is preferred way of financing projects with or without heavypremium. It suits corporate many ways.

- 28 - V. Recommendationsa) Debt Manager

The concept of debt manager : The concept of ‘debt manager’ appears to be

quintessential for the development of corporate debt market. This group ofintermediary should be an exclusive one and they should be committed andsufficiently capitalized. All the public / private issues will be placed throughthis debt manager. In order to provide competitive market environmentsufficient number can be licensed, provided they meet entry norms. Entry andexit should be free.

Debt manager can subscribe, hold and trade in debt. They would not beallowed to operate in other markets till the debt market attains certain criticalmass. This process is expected to provide supply of quality paper, increasedconfidence, increased liquidity etc. They can create liquidity in the market byproviding two-way quotes in all market conditions.

to be identified in order to evaluate debt manager’s ability to manage theirprimary and secondary market obligation. For risk management, minimumcapital requirements should be set up according to the degree of riskundertaken by debt manager.

§ Entry and exit criteria: Entry barriers should be low in order to have largenumber of debt managers. In fact both entry and exit should be free as long asdebt managers satisfy the minimum conditions. They should be allowed tolend and borrow securities amongst themselves in order to provide liquidity invarious instruments.

§ Monitoring of trade: To monitor the trading activity of debt manager,

electronic database of trading practice should be established. Monitoring isessential to ensure that they carry out their responsibilities properly. Its

- 29 -dissemination to investors should be facilitated at an affordable rate. Thisdissemination of information could be done in form of a “Bulletin Board”maintained by the exchanges/clearing corporation. This dissemination need notbe on real time basis. Even ex post facto reporting at the end of the day will putsignificant pressure on the dealers to be honest and fair to the investors. Theprice reporting and trading practice surveillance may be linked to thecentralised clearance, settlement and depository systems.

§ Punishment on default: In case debt managers do not carry out their

obligations, proper penalising framework should be put in place. In order toensure that debt managers take their responsibilities seriously, a system asmentioned above should be developed for monitoring and enforcing of theirobligations. Their performance should be evaluated on a quarterly basis. Whena system is fully automated, breach of the market-making obligation shouldlead to suspension of these intermediaries and other penalties as per theapplicable regulations as and when framed.

b) Trading Platform

Single vis-à-vis Multiple: It has been observed that multiple agencies

competing for market share in a small market mostly fragment the marketthereby reducing liquidity. In case of India, liquidity in the debt market is verypoor. Moreover, NSE and BSE have been promoting trading in corporate debt.If one goes by the above argument it seems that liquidity is getting bifurcatedhere. If other exchanges also join this competition in future, it would lead tofurther reduction in liquidity as well as increase in costs. One of the solutions tothe above problem can be in the form of ‘Single Trading Platform’. To initiatethis, exchanges can put joint effort for the development of the single tradingplatform.

However, the other side to the above solution is that a single trading platformcan create monopoly. Availability of alternatives provides a comfort zone andhelps in encouraging competition amongst the players

In such a scenario, the obvious alternative is to have multiple trading

mechanisms. One option is to allow multiple trading mechanisms to co-existbut requires a central collection and dissemination of prices. Such an approachis adopted in USA where all trades in the G Sec market are reported to the so-called Gov PX systems. The Gov PX system makes information available to

- 30 -subscribers for a fee. However, in case of India, initially, information needs tobe provided freely to create awareness.

Multiple trading mechanisms should come up with following features-

§ No operational arbitrage: Care should be taken that no operational

arbitrage may arise if multiple trading platforms exist.

§ Closed domain for trading: As debt is largely a wholesale market, it is

preferable to keep trading in this segment closed amongst specified investors.The logic behind having a closed domain for trading lies in the inherentcharacteristic of this market. This market differs from the equity market, asevery transaction has an impact on the yield of other papers unlike the equitymarket where scrips trade individually without a corresponding impact on theprices of other scrips. Thus if trading is allowed in all sizes, which is apossibility if trading is done at a retail level, the market could be distorted.Hence , it should be closed to a specified set of investors.

Closing the market to few shareholders does not imply that it will be restrictedto qualified institutional buyers (QIBs) only. Any investor who is willing totrade above a certain amount would be allowed to operate in the market.Another argument that goes in favour is that for any investor who wants toinvest a small amount, there exists no incentive to enter this market because ofthe presence of small saving schemes which give them similar or better returnwithout equivalent risk (in fact less risk).

c) Bond Market Information and Central Database

The Problem and solutions: One of the major problems in Indian corporatedebt market is lack of data in terms of its correctness, quantity and updation.Urgent need exists to create reliable and up-to-date database. There is no singlesource accessibility in India where data pertaining to corporate debt issue isavailable. No one knows exactly how much debt is outstanding on any givendate and different agencies have incoherent estimates of the data. Hence, anyregulatory actions either become ineffective or misdirected leading tounintended results. Therefore, there is an urgent need to launch a survey andprepare comprehensive database on few selected parameters from topcompanies. In this regard, following steps can be taken-

- 31 -§ Maintain a website for information dissemination: Leads can be takenfrom United States of America where the Bond Dealers Association maintains asite called www.investinginbonds.com, which gives detailed information aboutthe available debt securities simultaneously giving details about the risksinvolved in investing in bonds and guiding them as to the investment strategy.In case of India, there is a portal called debtonnetindia.com - a joint venture ofthe IL&FS and NSE. It is a virtual book-building portal, which acts as aninternet-based book for placing issues. Investors can bid for the issue throughthe portal, which enables the lead manager to build and close the book for theissue. This portal can be further expanded on similar lines to make it moreinformative.

In addition, one can emulate the practice of NASD where in all the firmstrading in corporate bonds are required to report trade data on secondarymarket transactions to NASD. NASD then disseminates trade information ofthese transactions s to public through its web site. This gives investors anopportunity to view real trade information.

brokers, ‘debt manager’, rating agencies and other concerned should regularlyprovide information on various parameters. This should be available freely onthe websites and trading platforms.

§ Depositories as source of information -Depositories can act as a major source

of information as they can disclose the amount of transactions that takes placewithout disclosing the name of the participants.

§ Trade at OTC- Even trades that take place in the OTC market should becompulsorily reported and information dissemination should be as good as inthe others segment of the market. This effort would help to take informeddecision.

d) Repo Market in Corporate Debt

The concept and the need: Repo transactions enable dealers to finance longpositions and cover short positions allowing them to respond to investor’sneeds quickly. In the Indian scenario, Government securities are the mostpreferred instruments for repo transactions. As of now, there are no takers forrepo transactions where corporate bonds are used as collaterals. This is so

- 32 -because the corporate bond markets do not possess some of the basicrequirement to get qualified for repo purpose.

Few of the problem areas as identified in the Indian case are as following:§ Shut down period –The market participants feel that shut down period needsto be cut down from fifteen days in the current scenario to three days. Thismove is justified because dematerialisation is widely prevalent today.§ Net-off period –Net off should be allowed for repos as they can make marketseffective.

e) Private Placement of Corporate Debt

The Problem: In 2002-2003, the amount of funds raised by privately placed

debt was Rs 48,424 crore as against Rs. 10,035 crore in 1995-96. This rise hasbeen witnessed because this segment requires minimum disclosure.

According to the Companies Act 1956, a corporate entity issuing debt is

mandated to make full disclosure as applicable to pub lic issues of equity capitalonly if the number of subscribers is more than 50. Corporate take advantage ofthis and make multiple issues in one year to meet their requirement makingsure that the number is less than 50.

Thus, steps need to be taken in order to address theses issues. Disclosure

should be made mandatory irrespective of the number of subscribers. Recentlydisclosures have been made compulsory for all listed companies coming outwith private placement. If an unlisted company wants to come out with aprivate placement and intends to get it listed, disclosures have been againmade mandatory. However, the unlisted companies who do not fall under thejurisdiction of SEBI still are free to make private placement without adequatedisclosures. This needs to be plugged with the help of respective regulatorybodies or by expanding the jurisdiction of SEBI.

Private placement of debt should be encouraged subject to the following

conditions-§ All privately placed debt will be issued to qualified institutional investors aswell as to other institutions but not to the retail investors.§ All private placements will be carried out by debt manager and / or primarydealer.

- 33 -§ All private placements will be compulsorily admitted for listing and regularinformation should be made available as specified previously.

f) A Sound, Robust and Safe Market Infrastructure

The concept: Safety and standardization in trading and settlement practices

should be ensured. Standardized robust trading rules and a safe infrastructurehelp reduce hidden transaction costs and promote market liquidity. Safety intrading and settlement is a prerequisite for the existence of deep and liquidmarkets as more investors will be willing to trade in a safe market.

• Shorten settlement lags: Settlement lags need to be shortened to T+3 or

shorter, and to adopt delivery –versus payment (DVP) practices.• Establish a clearing corporation: This need to be done for the trades thattakes place on the WDM segment of NSE. A computerised clearing andsettlement system should be set up for the corporate bonds. (Look into theviability of the existing systems to act as one.)

In order to widen the investors’ base as well as expand the market, stepsshould be taken to link it to clearing houses of other countries. This was donein case of Hong Kong where Central Money Market Unit (CMU) was linked tothe Euro clear and Cedel. This international link helped in the promotion of thedollar debt securities to the foreign investors. All debt instruments clearedthrough the CMU are either immobilised or dematerialised, and transfer of titleis made in book entry form. The Hong Kong Monetary Authority (HKMA) hasbeen promoting the linkages in order to facilitate cross border trades ofsecurities in Asian times. In December 1997, the HKMA became a member ofReserve Bank Information and Transfer system (RITS) for Australiangovernment securities and Austraclear (for private sector debt securities inAustralia). The link enables CMU members to hold and trade securities in RITSand Austraclear through HKMA’s membership in both systems. Similar stepswere taken in respect of other countries like Korea and Reserve Bank of NewZealand. Initiatives like this would give an international dimension to thecorporate debt market.

Establishment of trade guarantee fund for the corporate debt needs to be

implemented as it can help to improve the health of the market a lot. In theinitial stages, it can cause pain but this is necessary to activate the market byincreasing its safety level.

- 34 -g) Regulatory Framework

Disclosure system and information: Fair disclosure of information about an

issuer and the securities that it is offering is vital to a functioning of a publicmarket for bonds or equities.

§ Mandatory disclosure: Adequate disclosure should be made mandatory.

Also required is that these disclosures should be enforced effectively so thatone can achieve the desired results. One of the areas where disclosures need tobe made compulsory is disclosures regarding product feature. Information onproducts feature should be also clearly specified. As most of the products differfrom each other, varying kind of disclosure may be required according to thevariety of products. Accurate and comprehensible disclosure of productinformation of debt issues is necessary to make the investors fully aware of therisk return trade off. Moreover, disclosure should focus on an issuer’screditworthiness rather than its relative prosperity.

§ Securities registration procedure: It should not be costly or burdensome

as it can discourage corporations from going to local bond market. As these arecost- benefit trade-off for the issuers due care needs to be taken. Costs can berelatively more if registration forms are lengthy/complicated, waiting period islong until the field registration statement becomes effective etc.

§ Short Selling: More liberal attitude needs to be adopted towards short

selling. The ability to short sell a security makes a market more complete. Inparticular, the ability to short sell and borrow a security promotes liquidity.

h) Widen Investors’ Base

Steps should be taken to widen the investor base. In order to achieve this Koreagave bank and other guarantees to the bond issuers. However, due to lack ofproper regulatory framework this system of guarantee did not succeed. Theguarantee insurance scheme far exceeded the ability of the insurancecompanies. In reality there was no authentic bond guarantee insurancebusiness that is one based on well-established risk management skills witheffective database and sufficient statistics. None of the guarantors seemed torealise the enormous risk involved in bond guarantees, and the fees chargedwere considered more like service rather than insurance premiums based onthe past statistics. In other words the scheme appeared to consider the

- 35 -guarantees as an easy way to increase revenues without exposing themselves tosignificant risk. In order to avoid such situation proper framework should beput in place.

However, these insurance companies in turn need to follow capital adequacy

regulation, corporate governance norms, international auditing standard etc.Regulations should be placed in order to ensure a proper framework for theworking of these guarantors. Besides providing guarantees, steps should betaken to instil confidence in the investors.

Bondholders should be also involved in managing post bankruptcy situations.

Through active bondholders’ interest and protective measures such asbondholder committees, bondholders can serve their purpose as well as thepurpose of the market as whole.

Though retail investors should not be allowed directly in the market they canbe involved indirectly in the market as has been done in the case of HongKong. Here government bonds were made popular amongst the retail investorswith the help of placing bank. Initially when efforts were made to make thebonds popular amongst the retail investors, insufficient application channels,obstacles form the stockbrokers and lack of investment knowledge of bondsamong the public did not let it take off. However, a new issue mechanism wasintroduced which offered more offering channels for investors to subscribe forbonds. The use of placing banks largely removed the impediments fortendering method. For the retail issue launched early in October 2001, thecorporation appointed 13 placing banks using over 625 branches to place thenew issues to retail investors. When retail investors applies for a new issue bythe corporation, he can go in person to a placing bank and fill in simpletransactions ticket there, or apply through its phone banking and internetfacilities. Placing banks keep custody of the debt securities for their customers.The corporation ensures that its retail bond issues have a secondary market. Itrequires placing banks to enter into an agreement with the corporation to makea market for the note holders until the specific bonds mature. To facilitatemarket making by the banks, the corporation sets aside a reserve amount of 20-30 percent of the issued amount of the retail bonds to facilitate the placingbanks to quote two-way prices in the secondary market. Even if placing bankhas no debt securities to offer, it is still require to quote a firm bid price for thespecific issue in which it has acted as a placing bank to the customer.

- 36 -i)The Role of Securitization

The Concept: Securitization refers to the issuance of new bonds collateralized

by a pool of assets which can be other bonds, loans, or any receivables with aregular cash flow. This is usually done via a Special Purpose Vehicle (SPV)specifically set up to own and receive the income from the pool of assets, withwhich to service the bonds it issues in its name. Proceeds from the bond issueare used to pay the original owner or owners to acquire the pool of assets. Theoriginal owner or owners of the assets, or by a third party can set up the SPV.

The pooling of assets can provide diversification benefits to potential investors.

The asset-backed securities can be issued in several tranches of differentmaturities and offering different risk-return configurations, and can be rated atdifferent credit levels. Specifically, credit guarantees can be used to enhance thecredit worthiness of some of the tranches, making them eligible to a widerrange of investors. Credit enhancement can also be achieved through the over-collateralization of the asset-backed securities. The asset-backed securities canbe issued in bigger sizes than usually the case in emerging corporate bondmarkets, and therefore likely to have better liquidity in secondary markets—again desirable characteristics for investors.

Consequently, securitization can contribute to the development of corporate

bond markets by overcoming the problems of the small size and low creditquality of most emerging market issuers—problems which have plagued theemerging corporate bond markets. By participating in a securitization program,or by collateralizing their future-receivable cash flows, small and mediumcorporates are able to tap capital markets. In particular, securitization has beenan important tool to clean up banks’ balance sheets and improve their capitalratios in a bank restructuring process.

However as securitization is a derivative product, being packaged from

existing securities or other debt instruments, for its market to functionproperly, the market and market infrastructure for the underlying assets haveto be already in good working order. On top of that, legal clarity andpredictability on things like the true sale of assets, the taking possession ofcollateral and realizing its market value etc. also needs to be sufficientlyassured. Consequently, some analysts doubt if securitization can be used as ameans to help develop bond markets, as the cash market has to be relativelydeveloped before a market for securitized instruments can be introduced. In

- 37 -addition, to be viable, an asset-backed securities market needs to have in placeinstitutions ready and able to provide credit guarantees or to buy the higher-risk “mezzanine” tranches of the securitization program. But in India sincebond markets have been in existence for some times, securitization can beuseful in identifying gaps and deficiencies in cash market infrastructures andfoundations.

This in turn can help stimulate further reforms and developments in cashmarkets and beyond, in order to accommodate the proper functioning ofsecuritization markets. Research work done by the HKMA is consistent withthis line of thinking.

- 38 - VI. Conclusions

The study is basically explorative in nature. No empirical study has been

carried out. However, several practitioners, market participants,academicians and regulators have held threadbare discussions. A few ofthose recommendations are mentioned in this paper. The paper benefitedfrom the interaction that we had with all these people. Many of therecommendations, if implemented in Indian Corporate Debt Market, arelikely to make it more mature.

- 39 - VI. Bibliography

1. The Development of Corporate Debt Markets in Emerging Market

Countries, The Emerging Markets Committee Of The International Organisation Of Securities Commission, May 2002.